What is the intuition behind cointegration? What does the Dickey-Fuller test do to test for it? Ideally, a non-technical explanation would be appreciated.
Say you need to explain it to an investor and justify why your pairs trading strategy should make him rich!
Answer
The standard story (also told by @vonjd) is of "The Drunk and Her Dog". This is based on "A Drunk and Her Dog: An Illustration of Cointegration and Error Correction" (1994). The story is itself based on the standard illustration for a random walk known as the "drunkard's walk".
The Dickey-Fuller test is used to check for a unit root. It can be used as part of the general Engle-Granger two-step method (although it isn't the only option).
In this case, while the two assets themselves are not stationary, you are able to test if the residuals between a regression of the two assets is stationary. Most people prefer another approach, the Johansen test, which uses a VECM model.
The intuition behind pairs trading is that two cointegrated instruments will follow the same long-run path (since they presumably have some common factor, such as they are both oil companies and are heavily influenced by the price of oil), and any deviations will ultimately return back to the mean. Needless to say, pairs trading (or any other form of statistical arbitrage) is still a risky endeavor, as should be clear by the performance of arbitrage funds.
No comments:
Post a Comment